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Are Dividend Investors Getting More Than They Bargained For With Contact Energy Limited's (NZSE:CEN) Dividend?

Simply Wall St

Today we'll take a closer look at Contact Energy Limited (NZSE:CEN) from a dividend investor's perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

With Contact Energy yielding 4.8% and having paid a dividend for over 10 years, many investors likely find the company quite interesting. We'd guess that plenty of investors have purchased it for the income. Some simple research can reduce the risk of buying Contact Energy for its dividend - read on to learn more.

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NZSE:CEN Historical Dividend Yield, May 21st 2019

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Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. So we need to be form a view on if a company's dividend is sustainable, relative to its net profit after tax. In the last year, Contact Energy paid out 153% of its profit as dividends. Unless there are extenuating circumstances, from the perspective of an investor who hopes to own the company for many years, a payout ratio of above 100% is definitely a concern.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Contact Energy paid out a conservative 46% of its free cash flow as dividends last year. It's disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Contact Energy fortunately did generate enough cash to fund its dividend. Still, if the company repeatedly paid a dividend greater than its profits, we'd be concerned. Very few companies are able to sustainably pay dividends larger than their reported earnings.

Is Contact Energy's Balance Sheet Risky?

As Contact Energy's dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. A quick way to check a company's financial situation uses these two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA measures a company's total debt load relative to its earnings (lower = less debt), while net interest cover measures the company's ability to pay the interest on its debt (higher = greater ability to pay interest costs). Contact Energy has net debt of less than two times its earnings before interest, tax, depreciation, and amortisation (EBITDA), which we think is not too troublesome.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Interest cover of less than 5x its interest expense is starting to become a concern for Contact Energy, and be aware that lenders may place additional restrictions on the company as well.

Consider getting our latest analysis on Contact Energy's financial position here.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. For the purpose of this article, we only scrutinise the last decade of Contact Energy's dividend payments. This dividend has been unstable, which we define as having fallen by at least 20% one or more times over this time. During the past ten-year period, the first annual payment was NZ$0.28 in 2009, compared to NZ$0.35 last year. This works out to be a compound annual growth rate (CAGR) of approximately 2.3% a year over that time. The growth in dividends has not been linear, but the CAGR is a decent approximation of the rate of change over this time frame.

Modest growth in the dividend is good to see, but we think this is offset by historical cuts to the payments. It is hard to live on a dividend income if the company's earnings are not consistent.

Dividend Growth Potential

With a relatively unstable dividend, it's even more important to evaluate if earnings per share (EPS) are growing - it's not worth taking the risk on a dividend getting cut, unless you might be rewarded with larger dividends in future. It's not great to see that Contact Energy's have fallen at approximately 3.4% over the past five years. If earnings continue to decline, the dividend may come under pressure. Every investor should make an assessment of whether the company is taking steps to stabilise the situation.

Conclusion

Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. We're not keen on the fact that Contact Energy paid out such a high percentage of its income, although its cashflow is in better shape. Earnings per share have been falling, and the company has cut its dividend at least once in the past. From a dividend perspective, this is a cause for concern. Overall, Contact Energy falls short in several key areas here. Unless the investor has strong grounds for an alternative conclusion, we find it hard to get interested in a dividend stock with these characteristics.

Without at least some growth in earnings per share over time, the dividend will eventually come under pressure either from costs or inflation. See if the 7 analysts are forecasting a turnaround in our free collection of analyst estimates here.

We have also put together a list of global stocks with a market capitalisation above $1bn and yielding more 3%.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.